Charles Dharapak/AP
Treasury Secretary Henry Paulson

The Hidden Cost of Government Bailouts

September 25, 2008 08:51 AM
by Anne Szustek
Much has been ado over the pending $700 billion Wall Street bailout from the feds. But in the end, what is the real cost to taxpayers?

Bailout Bills

The Treasury Department and Congress are hashing out the details of what could be the biggest-ever federally funded rescue package for America’s financial sector—a proposed $700 billion to buy out financial firms’ bad mortgage debt. Some legislators are putting the price tag as high as $1 trillion.

The plan would give Treasury Secretary Henry Paulson the right to buy up “residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages,” The Economist quotes the proposal’s text as saying. A supplement from the Treasury expanded this to encompass “other assets, as deemed necessary to effectively stabilize financial markets.” Should the proposal go through, Paulson will have to report to Congress three months from the date the ruling becomes effective, then every six months from that date forward.

On Tuesday Paulson and Federal Reserve Chief Ben Bernanke started two days of Congressional hearings on the bill. The two key sticking points that could hold up the proposal in Congress are a cap on pay for executives at banks getting funding from the bailout and amendments to bankruptcy codes that would allow judges to modify mortgage terms. The proposal now incorporates two major Democratic demands: more assistance for those at risk of foreclosure on their homes and greater supervision over the financial sector’s mending process.

But for the moment, economic analysts sit and wait. Giri Cherukuri, the head trader at OakBrook Investments in suburban Chicago, told Reuters, “The big detail we want to know is how is the government going to buy these securities, and what they will pay, how that reverse auction will work.”

Meanwhile the public wonders whether the government can cover the costs—and if not, who is going to foot the bill.

Opinion & Analysis: To turn a profit or not to turn a profit

Given the premise of the proposal—to have the government take over debt that could otherwise envelop the global financial sector—the idea that the bailout will turn a profit for the government is “inconsistent,” writes The Economist.

Paulson has pointed out that much of the $700 billion will be covered by payments from mortgage holders. Plus, many mortgage securities at risk of default are now flush with liquidity, because, as The Economist notes, “the paper no longer trades.”

If the government acquires the mortgage securities at discount and lets them appreciate in value, that could also bolster federal coffers.

“The government will back the bad debts and sell them as debt securities. For that reason, investors who buy the securities, not the taxpayers, will pay down the bad debt,” Alejandro Canandas, an assistant professor of economics and finance at Mount St. Mary’s University in Emmitsburg, Md.

But when parallels are drawn with Japan’s financial woes of late, the outlook for government bailout packages is not as sanguine. Aid for corporations, interest rate cuts and tax stimulus packages did not necessarily mean money was going back into the economy, and Japan’s Nikkei index showed sluggish numbers.

Historical Context: Prior government buyouts and their results

The Federal Reserve and four other Canadian and European central banks said on Dec. 12 they would inject close to $64 billion in emergency short-term loans to banks in an attempt to alleviate the global credit squeeze. The Fed’s liquidity plan will establish a Term Auction Facility to dole out the cash and encourage close coordination with several foreign central banks. According to MarketWatch’s Greg Robb, it is an admission by the Fed that its prior strategy of cutting interest rates did not buoy credit markets.

A more recent capital influx courtesy the Fed has got analysts abuzz as to its advisability, however. Last week insurer AIG received an $85 billion loan from the federal oversight body with an 11.5 percent interest rate. The loan effectively nationalized roughly 80 percent of the conglomerate.

AIG has said it plans to pay back the loan in full by selling off assets or bringing in more investors. On Tuesday, members of the law enforcement community announced that the FBI was investigating the insurer, as well as bankrupt investment bank Lehman Brothers and mortgage companies Fannie Mae and Freddie Mac.

Those two mortgage providers were themselves taken into U.S. government conservatorship on Sunday, Sept. 7.

The U.S. government has stepped in to bolster U.S. firms during financial downturns in prior decades as well. In 1979, as the country was wrangling with stagflation, Congress approved a $1.5 billion loan to U.S. automaker Chrysler. Its 1979 deficit was around $1 billion, making it at the time “the gaudiest splash of red ink in U.S. corporate history,” as Time magazine put it. Taxpayers were at risk of footing the bill if Chrysler, then the country’s third-largest carmaker, defaulted. Sen. Barry Goldwater, R-Ariz., was quoted by Time magazine as saying that the loan was “the biggest mistake Congress has ever made.”

President Jimmy Carter signed the loan bill into law early January 1980. Over the following decade, under the leadership of CEO Lee Iacocca, Chrysler crept out of near bankruptcy and quickly paid off its loans.

The bailouts from the savings and loan crisis of the late 1980s were much more costly. The market crisis, spurred on largely by bad home loans, led to Congress’s 1989 creation of the Resolution Trust Corp., meant to take on nonperforming loans and real estate bearing down on failed banks.

The RTC originally had $50 billion in capital, 40 percent of it provided by the Treasury and Federal Home Loan Banks; and the remainder from a public-private funding corporation. This was shown to fall way short of the assets needed to clean up the $519 billion in assets of the 1,043 banks closed by the RTC and the Federal Savings and Loan Insurance Corp. between 1989 and mid-1995, and Congress upped funding to $105.1 billion.

But the bill to smooth over the savings and loan crisis officially totaled $153 billion, once interest costs for federal bonds and lost government revenues were factored in.

The FDIC, into which the RTC was rolled in 1996, estimates that taxpayers shelled out $124 billion to pay for that bank crisis, with the savings and loan industry putting in the remaining $29 billion. “Other estimates for the total S&L cleanup run as high as $500 billion when the economic cost of lost gross domestic product is included,” reports Reuters.

The United Kingdom has had its share of parallel nationalizations, both recently and under past prime ministers.

On Feb. 17, 2008, U.K. Finance Minister Alastair Darling announced plans to nationalize Northern Rock, Britain’s fifth-largest mortgage lender, and to authorize the takeover of any other banks failing within the next year. Northern Rock suffered heavy losses following the sub-prime mortgage crisis in the United States. Last September, the bank saw Britain’s first run on deposits in over a century.

So far, Northern Rock has been struggling. In August the bank reported first-half net losses of £592 million, or some $1.12 trillion, for the first half of 2008. Its net income was some negative $73.71 million, and it announced plans to lay off 1,300 employees in July.

In 1971, the British government under Conservative Party Prime Minister Edward Heath nationalized Rolls Royce after it filed for bankruptcy. The development of the RB-211 engine was proving too lengthy and costly for the company. Questions remained as to the viability of its longstanding contract with Lockheed. The car production unit would be spun off into its own company in 1973. What was left of the company, namely the aviation divisions, was privatized in 1986 during the tenure of Conservative Prime Minister Margaret Thatcher. Rolls Royce the car production company is currently owned by German automaker Volkswagen, who bought it in 1998; Rolls Royce the aviation parts company is still independent, and is the world’s second-largest producer of aircraft engines after General Electric.

On the flipside, British Leyland, a combined group of British car makers established by the Labour Party in the private sector in 1968 and taken into state control in 1975, was dubbed by the BBC “one of the biggest disasters in the history of nationalization.” Before it was nationalized, it had become evident that the conglomerate was struggling to compete against international car brands. After Britain took British Leyland into control, the company’s share of the market continued to dwindle. Car makes known traditionally to be British, such as Jaguar, MG and Aston Martin, are now all under ownership by foreign parties.

Reference: Finance guide


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